The Ugly Truth
Junk rating in waiting?: Puerto Rico’s general obligation (GO) debt is currently rated BBB- by the agencies, still investment grade. The market sees it another way (as evidenced by the very high borrowing costs being imposed for market access). Based on market pricing, the implied rating is arguably already below investment grade.
Downgrade damage: Ultimately, a downgrade to “junk” by the agencies will mean more forced selling, as investment-grade portfolios are required to sell down their non-investment-grade exposure to remain within investment parameters.
Despite a recent uptick, the Puerto Rico index is down more than 15% year-to-date. A downgrade could result in additional loss in value — or worse, a deterioration in liquidity that would make it difficult to get out of Puerto Rico bonds.
What’s an Investor to Do?
Puerto Rico debt recently rallied as some investors appear to believe the worst has passed. However, the underlying fundamentals have not changed, and that will likely be acknowledged again by the market. Until then, the recent strength might present an opportunity for investors to pare back their exposure.
More broadly, we suggest investors keep an eye on their mutual funds. Morningstar estimates roughly 77% of U.S. muni bond funds hold Puerto Rico-related debt. Given the triple-tax-exempt nature of Puerto Rico bonds, they are popular in national and state-specific funds. Ensure that any of these types of portfolios you may own do not contain a level of exposure higher than your comfort zone.
Above all, as I’ve said before, credit research is critical. There are big disparities across credits and issuers, even in Puerto Rico. Knowing what you own can make all the difference between success and failure in the muni market today.
Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group and a regular contributor to The Blog. You can find more of his posts here.
Sources: BlackRock, Puerto Rico Commonwealth Financial Information & Operating Data Report, Moody’s, S&P, Bureau of Labor Statistics, Puerto Rico Electric Power Authority.